The New Price of Expatriation

The American Jobs Creation Act of 2004 signed by President Bush on Oct. 22 expands the number of people subject to the 10-year expatriation tax after they renounce their U.S. citizenship or end their long-term residency. It also expands the amount of information expatriates must provide to the federal government and increases the number of years they must provide that information. The new law fails

The American Jobs Creation Act of 2004 signed by President Bush on Oct. 22 expands the number of people subject to the 10-year expatriation tax after they renounce their U.S. citizenship or end their long-term residency. It also expands the amount of information expatriates must provide to the federal government and increases the number of years they must provide that information.

The new law fails to resolve one of the more troublesome questions in expatriation law: Does the so-called Reed Amendment really give the government the right to prevent those who renounce their citizenship from ever returning to the United States?

The new rules affect individuals who expatriate after June 3, 2004. It is therefore essential that advisors quickly familiarize themselves with the new requirements.

PRIOR LAW

Before the Jobs Act, Internal Revenue Code1 Section 877 provided that an individual who expatriated with tax avoidance as a principal purpose was subject to a special income, estate and gift tax regime for 10 years after he expatriated (the “alternative tax regime”).

Section 877 created a presumption that an expatriate had tax avoidance as a principal motive if (1) his average net income tax exceeded $124,000 a year for the five taxable years preceding his expatriation or (2) his net worth was $622,000 or more as of the date of expatriation.2

Certain categories of individuals were permitted to prove that tax avoidance was not their principal purpose by submitting, within one year of the date of expatriation, a ruling request to the secretary of the Treasury Department. The individuals permitted to submit this request were (1) expatriates who at birth became citizens both of the United States and another country and remained citizens of that other country; (2) expatriates who (no later than the close of a reasonable period after the loss of their U.S. citizenship) became citizens of the country where they, their spouses or either of their parents were born; (3) certain long-term foreign residents; and (4) individuals who expatriated prior to age 18 1/2.

The income tax consequences of being deemed tax-motivated are significant and last for 10 years after expatriation. The expatriate is subject to U.S. income tax on U.S. source income at the rates applicable to U.S. citizens. The definition of “U.S. source” is broadened to include gains arising on the disposition of U.S. personal property (including U.S. stock and debt obligations). Gains and income received by a controlled foreign corporation controlled by the expatriate also will, in certain circumstances, remain subject to U.S. income tax.3 During those 10 years, a “tax-motivated expatriate” also remains subject to U.S. estate tax on his U.S. situs assets (including a proportionate share of such assets held through a controlled foreign corporation) and U.S. gift tax on the transfer of U.S. situs intangibles, such as stock in a U.S. company.4

NEW LAW

The Jobs Act replaces what was a subjective intent test with a new objective test. The new law has eliminated the ruling request procedure in which the Internal Revenue Service determines the expatriate's motive.

With two exceptions, the new expatriation rules apply to U.S. citizens who renounce their citizenship and to certain long-term resident aliens who terminate their residency regardless of intent if (1) their average net income tax exceeds $124,000 a year for the five taxable years preceding their expatriation, (2) their net worth is $2 million or more as of the date of expatriation or (3) they fail to certify under penalties of perjury that they have met the requirements of the U.S. federal tax law for the five taxable years preceding expatriation or they fail to submit evidence of compliance as requested by the secretary of the Treasury.5

There are two very narrow exceptions to these rules: one for dual citizens and the other for certain minors. The alternative tax regime will not apply to a citizen who at birth became both a citizen of the United States and another country and who continues to be a citizen of the other country and has had no substantial contacts with the United States. An individual has had no substantial contacts with the United States only if he (1) was never a U.S. resident,6 (2) never held a U.S. passport and (3) was not present in the United States for more than 30 days in each of the 10 years preceding the date of expatriation.

The alternative tax regime also will not apply to a minor who became a U.S. citizen at birth if neither of his parents were U.S. citizens when he was born. This person must have expatriated from the United States before age 18 1/2 and cannot have been present in the United States for more than 30 days in each of the 10 years preceding the date of expatriation.

The new law includes a mechanism for drawing expatriates back into the U.S. tax net. Specifically, if during the 10 years following expatriation, an individual is physically present in the United States for more than 30 days in a calendar year, he is taxed in such year as a citizen or resident of the United States (whichever is applicable) for income, estate and gift tax purposes. That is, he will be subject to U.S. income tax on worldwide income and estate and gift tax on worldwide assets.

For certain expatriates, a day of physical presence7 in the United States would be disregarded if the expatriate was performing services for an unrelated employer.8 An expatriate falls within this exception if (1) no later than the close of a reasonable period after losing U.S. citizenship, he becomes a citizen of the country where he, his spouse or either of his parents were born and becomes liable for income taxes in that country,9 or (2) for each year in the 10-year period prior to expatriation, he was physically present in the United States for 30 days or less.10

Generally, the amendments to IRC Section 877 expand the class of individuals subject to Section 877 but they do not substantially change the 10-year taxation of expatriates. There are, however, important changes to the 10-year alternative tax regime. For example, the new law extends the application of the gift tax to an expatriate's transfer of stock in a controlled foreign corporation, whether or not such stock is situated in the United States. As a result, the gift tax provision relating to an expatriate's transfers of stock in a controlled foreign corporation conforms with the estate tax provision relating to stock in a controlled foreign corporation owned by an expatriate at his death, as described in IRC Section 2107(b). In addition, the treatment of expatriates as U.S. citizens or residents under the 30-day physical presence provision is a significant departure from the old rule.

NOTICE AND REPORTING

The Jobs Act imposes several new burdens on individuals seeking to expatriate. Specifically, an individual will be treated as a citizen or resident of the United States despite his attempted expatriation until he gives notice either to the secretary of State or the secretary of Homeland Security of an expatriating act or termination of residency and provides a statement in accordance with IRC Section 6039G.

As under the prior law, the statement of information required by IRC Section 6039G must include: (1) the expatriate's taxpayer identification number, (2) the mailing address of the expatriate's principal foreign residence, (3) the foreign country in which the expatriate is residing, (4) the expatriate's country of citizenship, (5) a complete list of the expatriate's assets and liabilities and (6) any other information the secretary of the Treasury may prescribe. In addition to this information, the new law requires an expatriate to provide information relating to his income and the number of days that he was physically present in the United States during a taxable year.

Previously, an information statement was required only once, upon expatriation. Now an expatriate must file an information statement each year that he is subject to the alternative tax regime — that is, for 10 years following his expatriation.

The Jobs Act imposes a penalty of $10,000 for every failure to file an information statement. The penalty is imposed if the failure to report resulted from willful neglect but not if the failure resulted from reasonable cause.

REED AMENDMENT

In 1996, Public Law 104-208 enacted the Reed Amendment, which potentially bars a former U.S. citizen who has expatriated from ever returning to the United States, even to visit.11 The Senate proposal clarified the impact of the Reed Amendment. It denied an expatriate reentry into the United States only where it was determined that such expatriate was not tax compliant.12 Unfortunately, the Senate proposal died in conference and the new law fails to address the Reed Amendment problem. It appears that the new law indirectly recognizes that expatriates should be permitted to return to the United States, as evidenced by the 30-day physical presence test. Until the constitutionality and advisability of the Reed Amendment are finally resolved, it appears that the new legislation will be inconsistent with the Reed Amendment.

Although the Jobs Act provides a welcome amount of certainty to those contemplating expatriation by eliminating the subjective, tax-motivated test in favor of an objective, intent-neutral test, Congress's failure to clarify the impact of the Reed Amendment perpetuates the uncertainty for clients who may want to expatriate. It behooves Congress to address the Reed Amendment and its application to individuals who legally expatriate under the Jobs Act. Until then, an expatriate will have no guarantee that he can return to the United States.

Endnotes

Internal Revenue Code of 1986, as amended.

These figures are the amounts for 2004 and are adjusted each year for inflation.

IRC Section 877.

IRC Sections 2107 and 2501(a)(3).

As with the prior law, the net income tax amount is adjusted for inflation each year. In contrast, the net worth amount of $2 million has not been adjusted for inflation.

As defined in IRC Section 7701(b).

Not more than 30 days during any calendar year may be disregarded under this rule.

IRC Sections 267 and 707.

IRC Section 877(g).

This exception includes certain individuals not treated as physically present in the United States under IRC Section 7701(b)(3)(D)(ii), including teachers, students, foreign government related individuals or individuals remaining in the United States due to a medical condition that arose while such individual was in the United States.

8 U.S.C.A. Section 1182(a)(10)(E).

See “What Price Expatriation?” Trusts & Estates, July 2003, for a full description of the Senate's proposal.